A Regulatory Brief from PwC “Broker-dealers: Lock in your Liquidity” (October 2015) looks at recent regulatory guidance on liquidity risk management from FINRA. While these are not rules per se, PwC expects that FINRA will enforce the guidance in exams and that the SEC will issue formal rules in 2016. Some of the guidance mimics others general rules we’ve seen from regulators, but there was some odd stuff in there. too.
From the report there were 5 areas that PwC highlighted:
- Maintenance of contingency funding plans and facilities should take place at the broker-dealer level.
Back up committed liquidity at only the parent level is viewed as inadequate. From the report:
“…FINRA found that such arrangements are inadequate because a parent is often committed to multiple affiliates. In the absence of exclusive contingent facilities, funding is less likely to be available to the broker-dealer during times when it is needed most…”
- Broker-dealers need to secure dedicated third party committed lending facilities with unrestrictive covenants.
This has potential to get tricky. Those committed lines absorb capital and won’t come cheap. FINRA wants to make sure the facilities aren’t “vapor lines” that in a stress situation can disappear. What about the systemic implications? Could a drawdown signal weakness not only from the borrower, but impair the lender as well?
- Broker-dealers must be realistic about the value of collateral when contemplating secured financing options.
From the report:
“…FINRA found that most firms’ haircut assumptions were overly optimistic, particularly for illiquid assets. To the extent that firms rely on secured financing, they should be extremely conservative when valuing their collateral…”
So haircuts will have to be stressed and firms tested if they survive a sudden shift higher in haircuts. Beyond that, given the focus on liquidity these days, broker-dealers may have to make some draconian assumptions about where their inventory might be valued in a high stress scenario. This begs the question about the type of collateral the b-d’s will hold. Will there be limits on less liquid holdings?
- Over reliance on the Fixed Income Clearing Corporation’s (“FICC”) General Collateral Facility (“GCF”) to replace existing repo financing is unrealistic due to the FICC’s capacity limitations.
This was the one which caught our attention. From the report:
“…The FICC’s rules limit GCF capacity to 140 percent of a firm’s activity for the previous 30 days. FINRA found that many firms’ liquidity funding plans relied on this avenue without accounting for this rule. …”
Cautioning against over reliance on FICC seems to be code for sourcing liquidity away from inter-dealer markets. In an idiosyncratic event, repo dealers will cut off a tainted broker-dealer. But what then? Why will, say, money funds or other non-dealer liquidity providers react any differently? How exactly does one fix this problem? Will FINRA be able to benchmark if a broker-dealer’s funding sources are adequately diversified away from FICC trading much less collect and analyze the numbers? Regarding the 140% FICC limit (which wee admit is new to us) will firms look to inflate their repos and reverse FICC activity (netting the trades down to avoid blowing up balance sheet in the interim) to keep their numbers artificially up and create a high base? Will this effectively circumvent the 140 percent rule?
- On-going funding and liquidity risk assessments will be expected.
This one seems like common sense. Bt will this be done at a fairly high level or get into the weeds? Broker-dealers will be hauling out their crystal balls for this and that is never good. While liquidity and funding management is nothing new to the securities financing industry, the devil will be in the details.